Lessons From 2011: What Will Happen to the Economy After a Cliff Deal

The on-again/off-again fiscal cliff negotiations look like they may finally be nearing a deal — although such rumors have come and gone repeatedly in recent weeks. But assume for a second that Congress and the President really have reached an 11th hour deal to avert the worst of the cliff’s tax hikes and spending cuts—how lasting will the damage be from the weeks of brinksmanship?

This is a separate question from the impact of the actual policies contained in a deal. Pretty much any deal that could pass muster in both houses of Congress would involve tax increases and likely also spending cuts, and would therefore be at least a short-term drag on economic growth. (The longer-term impact of a deal that grappled seriously with the nation’s budget deficits is harder to gauge.)

But what about the debate itself: Would policymakers’ willingness to play chicken with the economy — and their apparent inability to reach a deal until the last possible moment even in the face of near-certain recession — have its own impact on economic growth? Odds are that we’ll know for sure in a matter of weeks. But in the meantime we can look at the closest recent parallel: last year’s battle over raising the debt ceiling.

A quick refresher: In the summer of 2011, a battle broke out in Washington over whether to raise the nation’s borrowing limit, which had until then been a fairly routine practice. The prospect of hitting the ceiling — which in theory could have forced massive cuts in government spending, or even led the U. S. to default on its debts — roiled financial markets and led to a steep drop in consumer sentiment. Congress eventually agreed to raise the debt ceiling via a last-minute agreement that ultimately paved the way for the current crisis. But the stopgap deal wasn’t enough to prevent Standard & Poor’s from downgrading the nation’s triple-A credit rating, which further hurt both markets and confidence.

But the lasting impact of the debt-ceiling drama is far from clear. Consumer sentiment took months to rebound, and markets didn’t return to pre-crisis highs until early 2012. However, most measures of real economic activity either quickly rebounded or never fell at all. Growth in Gross Domestic Product slowed to 1.3% in the third quarter of 2011, down from 2.5% in the second quarter, but bounced back to 4.1% in the final three months of the year — the best mark in the recovery. Consumer spending actually accelerated in the third quarter of the year, as did measures of business investment and manufacturing activity. Job growth did slow markedly in the summer of 2011, a possible sign of caution among businesses, but there were similar hiring slowdowns in both 2010 and 2012 — and in any case, hiring rebounded in late 2011 and early 2012.

It’s always risky to read too much into just one data point, and there are clear differences between last year’s situation and the current one. For one thing, the debt-ceiling debate was a more or less binary event: Either Congress would raise the debt ceiling, or it wouldn’t. Once it did, the immediate threat passed. This time, there are a wide range of outcomes, nearly all of which would involve at least some short-term drag on growth. The debt ceiling was also a mostly theoretical issue for most Americans, whereas the fiscal cliff would mean an immediate tax increase for virtually all U. S. workers. Moreover, repeated flirtations with disaster could have a cumulative effect, leading investors and consumers to lose confidence in their leaders.

Still, there are some similarities between the two situations. As the Journal noted today, consumer confidence and stock prices have already taken a hit from the cliff debate. But as in 2011, actual economic activity is sending more mixed messages. Business investment has slumped severely in the second half of the year, perhaps due to fears of the looming cliff. But hiring has remained fairly steady, and income and spending figures came in stronger-than-expected in November. One reading of the 2011 experience would be that if Congress and the President reach a deal, the big drop in confidence won’t translate into a real hit to economic growth.

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